Sunday, January 3, 2010

Do Budget Deficits Drive Bond Yields?

(Due to a long-planned vacation out of the country, there will be no articles posted during that period, starting Monday, January 4th. New posts will resume after January 19h).


The notion that large budget deficits tend to lead to higher yields has generally been accepted over the years without much questioning among market participants. The basic idea is a fairly straightforward one: the large supply of securities associated with those deficits can cause an over saturation in the credit markets, creating a mismatch between supply and demand and, therefore, leading to lower prices (i.e higher yields).

The academic literature in the field of economics reaches essentially the same conclusion, by highlighting the so-called "crowding out" dynamic- which means that the intense competition for funds between the government and private sector in a period of large government issuance will squeeze out private borrowers while causing rates to rise.

The prospect of massive Treasury supply ahead has, in fact, been invariably mentioned as one of the main reasons for which long-term yields have backed up moderately in the last five weeks and are viewed as likely to drift higher in 2010 in good part due to that factor. It is, however, curious that, despite the very mixed, at best, evidence that Treasury supply has any lasting effect on Treasury yields, that notion continues to hold sway among fixed income market participants.

A classic, and fairly dramatic, example where that purported relationship was actually turned on its head in this country was in the '80s. Between 1981 and 1986, the budget deficit tripled in size (to a new record by the then historical standards), while the benchmark 30-year Treasury bond yield collapsed from approximately 15% to 7.5%. The main driving force of yields at the time was the aggressive easing by the Fed, reversing the spectacular tightening that had been put in place at the beginning of the decade to fight runaway inflation. With the Fed easing at a breathtaking pace and inflation falling rapidly, bond yields did not seem to care about the mushrooming budget deficit.

In the late '90s again, when the budget situation switched from a $107 billion deficit in fiscal 1996 to a $236 billion surplus in 2000, the presumed scarcity of Treasury securities did not appear to have any measurable effect on long-term yields, which remained essentially in the vicinity of 6-6.5%.

There is probably no more spectacular case where the purported connection between supply of government securities and bond yields has been challenged "head-on" than Japan. The country has been running enormous budget deficits for more than a decade now, with its cumulative government debt running above 200% of GDP currently (approximately 3 times higher than that of the U.S.). Still, 10-year JGB yields have remained almost consistently within a 1% to 2% range during most of that period.

In the case of Japan, the answer to the seeming paradox lies in two very important factors: a) the availability of a large domestic pool of savings that sustains a strong demand for government-issued debt, and b) a broadly deflationary environment for most of that period, suggesting that as long as real returns on 10-year JGBs remain within a 1.5% to 2.5% range, domestic investors will remain attracted to such paper at still very low nominal yields.

It is certainly true that differences do exist between Japan and the U.S. in regards to the fiscal dynamics. Although the first of the above two factors related to Japan's case is not applicable in the case of the U.S, the latter factor is a universal principle driving fixed income investment decisions and is likely to be a pivotal one in shaping the direction of Treasury yields over the next couple of years. If the Fed's handling of the exit strategy and the actual behavior of inflation convey a reassuring message in terms of the overall price outlook as the economic recovery gathers momentum, the back-up in yields should be relatively moderate- almost irrespective of the amount of new supply; the unique qualities of liquidity and depth that the U.S. Treasury market possesses should remain attractive in the eyes of foreign investors

To be sure, significant changes in the supply situation can very well influence appreciably market psychology for some time and add to a potential setback that yields could suffer in the midst of an economic recovery that is still likely to show more life than had been generally assumed until a couple of months ago. But supply alone is unlikely to become the defining driving force for any sustainable period of time, if a number of other key elements of the underlying fundamentals continue to make Treasury securities an appealing place to be.

None of the above is meant to imply that large budget deficits do not matter at all, as they continue to increase the reliance of this country on foreign sources of financing, with all of the associated potential (at least, in theory) unpredictability; it furthermore continues to add to the national debt, which, at least on common sense grounds, does represent a disconcerting imbalance. But, supply, per se, has been wildly overestimated as a factor that can determine the direction of Treasury yields for any sustained period of time.

Anthony Karydakis

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